Despite COVID-19 and unrest around the globe, this year has finally seen semi-transparent active ETF launches from American Century’s ActiveShares to Fidelity’s Active ETFs. Although there is uncertainty of what each day, week or month will look like in the new normal, one thing is for sure, the interest for gaining more knowledge about semi-transparent active ETFs is growing. Following the SS&C ALPS webinar on the subject, we sat down with ETF Trends’, Director of Research, Dave Nadig, to get an authorized participants’ (AP) perspective around the flows for these new models.
Does the use of a proxy portfolio for creation/redemption baskets present a material market risk for APs and other market making participants?
Nadig: No not at all. Proxy portfolios are, by definition, designed to provide a high degree of intraday certainty around it. In fact, the existing practice in fully transparent ETFs is often not to buy a completely representative portfolio slice anyway, but a representative sampling and then a cash component—it’s almost mandatory in Bond ETFs, where there can be thousands of individual securities in the full portfolio.
What impact will rebalancing the proxy portfolios, in relation to creations and redemptions, cost the fund in execution costs and tax efficiency?
Nadig: Well, we don’t really know from an academic perspective. If the C/R baskets aren’t “perfect” then of course there will have to be a little bit of trading to true up the portfolio, and that cost will be borne by the fund, and any capital gains distributed. But because a lot of the C/R activity WILL happen in the baskets, it strikes me as unlikely this will be meaningful. You can create a scenario—wildly off baskets, extreme turnover—where it could be big, but I find it very unlikely.
The question was raised early on in the exemptive filing stage if an unknown basket would lead to wider spreads when compared to passive ETFs; based on the spreads American Century has had of late, they have gone from around 25 bps to 15 bps, so clearly this isn’t the case here. Is the market maker keeping it tight because they really want it to work and they have found their threshold, or is it really due to the demand? Also, how have your partners been able to handle efficient markets during the volatility, and what are your thoughts on the spreads during periods of volatility?
Nadig: The short answer here is that the funds that have launched so far—regardless of which structure they’re using—haven’t had any big blowouts in spreads on volatile days, or big deviations from fair value. In other words—stuff’s working. These aren’t designed to be trading vehicles—all the products launched so far are really buy and hold vehicles. So 15-25 bps as a consistent spread is 100% in line with other small ETFs. Better than some!
What are you watching and what should one watch for? We’ve all been on lots of panels around semi-transparent active ETFs; what do you think has been missing from the conversation—say a year from now, what will be the “why wasn’t this brought up before or why are we just considering this now after all this time?”
Nadig: Honestly—just demand. We haven’t seen a big surge of investor money being interested yet. ACI has pulled in a little money, but I suspect that’s been from institutional transfers from the like-mutual fund or separate account strategies. The big unknown remains “will anyone care.”
In your opinion, what do you think the survival of these models will be in the long term?
Nadig: I think we’re rapidly going to move past the “does the structure work” discussion—it clearly does. So now active managers just need to convince investors their strategies are great. Sadly, it’s likely all going to come down to performance.
Some say that the ETF Marketplace has become saturated as most asset classes are covered by established funds. Given the limits of these models, what opportunities, in your opinion, exist for newcomers to the ETF space to utilize these models?
Nadig: There’s still a lot of room for growth in the industry, and I do think we’ll see traditional, non-ETF active managers keep launching product. Whether they use a non-transparent model like we’ve been discussing or not will be a firm-by-firm choice, and the ETF rule (6c-11) provides a strong incentive to go fully transparent if you’re coming into the market right now. Proving the need for delayed disclosure is a hard thing, especially as investors become used to more transparent products.
Does publishing a Verified Intraday Indicative Value (VIIV) calculated on actual fund holdings present an actionable opportunity for reverse engineering of portfolio strategies? Also, will not publishing an IIV on actual fund holdings lead to inflated spreads from traders making markets in those funds?
Nadig: I know some academic work has been done on this, but honestly, I think there’s a long chain of credulity that’s stretched if you think someone is actually going to build a frontrunning model based on VIIV regression analysis. These funds are currently “tiny” and it would take something truly monumental to make the effort even worth it. If a $100 billion fund with very high conviction, very high active share, and very high turnover was behind the VIIV? Maybe. But we’re a long, long way from that.
Will an unknown basket lead to wider spreads when compared to passive ETFs?
Answer: Theoretically it should. But the only truly “unknown basket” model is Precidian, and in that case, the “basket” from the market maker/APs perspective is actually cash! So there’s no reason to expect broad spreads.
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Asset Management, Wealth Management